LP disputes issues for VC firms in a Covid-19 context

Michael Cumming-Bruce

Downturns tend to see investors seek safety, potentially causing them to push for early liquidity events or to withdraw capital. VC firms, on the other hand, may want to negotiate extensions to the terms of funds or the ability to reinvest profits to meet capital needs in an environment where fundraising may be challenging. Such divergent economic interests between partners have potential for causing disputes, not least as increased capital needs at the portfolio company level are liable to require sensitive discussions about the need for increased backing with LPs, who may of course themselves be exposed to wide-ranging losses across their investment portfolio. While disputes with investors should of course be avoided, the current situation may not make that possible in all circumstances, and it may therefore be useful to consider contentious issues that may foreseeably arise, with a view to minimising their potential impact.

Assuming that the relevant fund is established as a partnership under the Limited Partnership Act 1907, the duties which the partners are subject will be governed by the partnership deed and by the 1907 Act. The partnership deed is reasonably likely to describe both the GP’s and the LP’s rights and obligations in some detail, including such potentially contentious matters as the length of time investor capital is locked in for, the circumstances in which capital may be returned and/or the circumstances in which profits may be reinvested. It may now be sensible for VC firms to dust off these agreements with a view to identifying which provisions might foreseeably give rise to conflict with investors, to better manage those issues ahead of time (e.g. by negotiating amendments to partnership deeds) before they have the opportunity to cause real problems.

There may be some circumstances where it is not possible to pre-emptively resolve potential conflicts with LPs. For example, some investors may decide they wish to exit the fund with the capital they invested, and in the absence of any entitlement to do so, litigate in the hope of forcing their partner’s arm into giving them what they want. The core duty owed by partners under English law is the duty of good faith and there is Court of Appeal authority that this duty extends to disclosing all material facts a prospective partner might not be aware of in the context of negotiating a partnership agreement. In some circumstances, this may allow unscrupulous LPs a relatively broad basis for alleging breach of duty based on a failure to make them aware of facts alleged to be material. In other cases, LPs aggrieved at having lost money on speculative endeavours may seek to actively recoup what they perceive to be avoidable losses from GPs, although partnership agreements may afford protections against such behaviour. In this context, it may also be comforting for GPs to note that leading English law commentators have considered that breach of the duty of good faith is liable to require more than negligence and that, while a partner is under a duty not to expose fellow partners to avoidable risks, this may not constitute an integral part of his/her duty of good faith (albeit that with legal disputes, as with most things, the particular circumstances are everything).

Many GPs are likely to be under considerable pressure to generate returns. In addition to the drumbeat from LPs in need of funds to meet their own capital requirements, VC firms may well be conscious that fundraising conditions in the foreseeable future are likely to be challenging, which may make being able to trumpet impressive historic rates of return all the more important. This may incentivise VC firms to try to exit their investments as quickly as possible and return capital to LPs, particularly as funds approach maturity. However, many potential buyers will be aware of this dynamic, which they may seek to leverage to drive down prices. Within reason, this may simply be a matter of commercial judgment. However, if assets are sold off at prices that some LPs regard as unconscionably low, GPs may risk claims of, for example, breaching duties by prioritising self-interest in generating respectable IRR for the purposes of future fundraising over the interests of the partnership in maximising profit.

If disputes arise and cannot be dealt with privately, VC firms may want to consider whether a form of alternative dispute resolution may offer a useful means of de-escalation and potentially mitigate the reputational and financial impact of what might otherwise be litigation or arbitration proceedings. To give two examples, early neutral evaluation involves an independent evaluator (often a judge) providing parties with an impartial assessment of the strengths and weaknesses of their cases, which can serve as a useful ‘cards on the table’ basis for reaching a commercial resolution (despite not being a formally binding decision). Alternatively, mediation is a well-known and flexible method of resolving disputes whereby an independent mediator will typically liaise with both parties on a confidential and without prejudice basis to seek a compromise, and is often successful in focusing parties’ minds on the key issues required to help reach agreement at the mediation or in its aftermath.

While this is by necessity a mere overview of the various contentious issues that may arise between LPs and GPs in the current environment, if further information on any of these matters would be useful please get in contact.

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